Opinion The year of useless increases
Raising rates has not helped the economy. Heres why cutting rates,instead,would work
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We seem to be in the midst of a scissors crisis. On the one hand,prices are rising; on the other,GDP growth particularly industrial growth is slowing down. Joseph Stiglitz,not long ago,argued that raising the interest rate is too blunt an instrument to tackle inflation in a complex economy like India,especially when the final victim is likely to be the growth rate. There is evidence for this in that India has experienced no let-up in rising prices,despite steadily rising interest rates over the past year,and that industrial growth has suffered. And,as Kaushik Basu points out,when Turkey lowered its interest rate last year,in the midst of high inflation,the inflation rate actually came down and,of course,the growth rate went up.
Each economy however,has its own circumstances; so for India let us consider the price rise in just two areas,fuel and food,which comprise a significant part (60 per cent) of the lower-middle and middle class budget. The recent rise in fuel prices has witnessed a huge outcry among consumers. The governments argument justifying it is that,since India is a free economy,the impact of a depreciating rupee must be borne by the consumer,else it will negatively impact the budget deficit and crowd out investment. The irony is that industry is hardly concerned about getting crowded out; its worry is shrinking market demand because of the paucity of consumer purchasing power after spending on essentials like food and fuel. Added to industrys woes is the the rising interest rates impact on the cost of borrowing.
The slowdown in the growth is already evident,with its concomitant negative impact on employment. The auto industry is a good example. Each car typically has 13,000 components; many supplied by fairly labour-intensive small and medium-sized enterprises. Even a small drop in the demand for cars therefore is likely to have a chain effect leading to unemployment down the line. Likewise for a range of assembled consumer products.
With a bleak economic outlook for the future,investment in industry and housing has almost dried up. This has been exacerbated by the import of plant,machinery and other inputs becoming costlier on account of the depreciation of the rupee. But why has the rupee depreciated? The general belief is that negative economic worldwide has caused the FIIs to pull out,and invest in gold and commodities. Bringing FII money back into the country will depend to a large extent on stockmarket trends,in turn a function of the growth outlook. Presently,however,with dire prospects for the US and Europe,a quick turnaround seems unlikely.
Food is in a somewhat different category from industrial goods. The problem of rising food prices can be divided into two parts. First,with general inflation the farmers clamour for higher procurement prices. This the government does periodically,thus adding to the inflationary trend. The second part of the problem however is more pernicious. Behind the delivery of food items to the consumer is a value chain comprising of procurement,storage,transportation,mandis,commission agents,wholesalers and unorganised retailers. So cumbersome is this process that the farmer typically gets for his produce just about 25 per cent of what the consumer pays.
The logical answer to bring down food prices therefore is to narrow the margin between the consumer and the farmer. One of the methods written about by many including myself,and supported by comprehensive studies by ICRIER,is to invite foreign direct investment (FDI) into food retailing; the key presumption here is that large organisations with access to capital and experience in bulk retailing will be able to streamline the value chain by for example providing adequate transportation and storage facilities,cold chain infrastructure for perishables,silos for grains and finally retail outlets or supermarkets. Such a model has been adopted in China,Singapore,Indonesia,Thailand,Brazil and Argentina.
In our case,despite rising interest rates for over a year,the impact on inflation has been negligible. Let us now consider what can go wrong (or right) if the interest rate is lowered. First,stockmarket sentiment should improve,giving the right signal to industry and the FIIs. Then,as and when banks reduce lending rates,industrys low capital utilisation should rise; housing and construction should improve,and consumer demand should go up. Thus employment should also rise. Government revenues needless to say will go up,with a positive impact on the budget deficit.
The impact of lowering the interest rate on food prices,however,is likely to be minor at least till the margins narrow,which can happen only when large-scale retailing of food through the FDI route is introduced.
To conclude therefore,let us go the Turkey way. An interest rate reduction can do no harm; raising the interest rate has done no good.
The writer is a visiting professor of economics at IIT,Delhi
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